Inflating the debt away

In many economies the total quantity of debt has become so high that repayment is no longer possible using the current supply of money. This means that default on a grand scale is inevitable, the only unknown being the nature of the default. One possibility is that most debt defaults will be the direct kind, while the only other possibility is that enough new money will be created to enable most debts to be repaid using substantially depreciated currency units. The second possibility is often described as "inflating away the debt".

The idea that there will be an attempt to "inflate away the debt" has become popular, partly due to the way the US Federal Reserve has reacted to financial crises and economic weakness to date. We wish to point out, however, that the economy-wide debt burden cannot possibly be reduced via monetary inflation unless the central bank makes a major change to the way it operates. The reason is that the way the monetary system currently works, almost all money is borrowed into existence (new money is accompanied by new debt). In other words, unless the central bank's modus operandi changes, it will not be possible to "inflate away the debt"; rather, faster money-supply growth and a resultant acceleration in the rate of currency depreciation will require a more rapid expansion in the total quantity of debt. Or, to put it simply: more inflation requires more debt.

Our impression is that most commentators who predict that the central bank and/or the government will try to "inflate the debt away" either don't have a good understanding of the process by which money is created or haven't thought through the mechanics of the inflation process in sufficient detail.

As long as new money is borrowed into existence, the economy's overall debt can't be "inflated away". However, under the current monetary system this doesn't restrict the amount of money-supply growth. The reason, to use Greenspan's terminology, is that a government with a captive central bank cannot become insolvent with respect to obligations in its own currency. A government can actually take on new debt ad infinitum provided that its central bank is prepared to purchase the debt.

An implication of the above is that if the central bank and the government want to bring about a rapid expansion of the money supply at a time when the private sector is reducing its collective indebtedness, they can do so by ensuring that government indebtedness grows at a much faster pace than private indebtedness shrinks. The overall debt burden expands, but the private sector becomes responsible for a lesser proportion of it.

So, if the Fed stuck to its standard operating procedures* it wouldn't be possible to "inflate away" the US economy's overall debt burden, but it certainly would be possible to substantially devalue the US dollar via a large increase in government indebtedness. This means that if all else remained the same, a large increase in government indebtedness and the monetary inflation associated with it could provide the private sector with a net benefit by reducing the REAL value of its debt. However, all else never remains the same. Although private-sector debtors could benefit from having their debts denominated in depreciated dollars, the market economy would be devastated by the extra costs and uncertainty caused by rapid currency depreciation, distortions of relative prices, and the expansion of government. In such an environment, people with significant real savings to invest would be inclined to either get their savings out of the country or protect their wealth by hoarding commodities. They would be disinclined to invest their savings in ways that create employment. That's why the historical record is unblemished by examples of the general public benefiting from a large inflation-fueled depreciation of the currency.

*Over the past two years the Fed has begun to deviate from its standard operating procedures in that it has begun to monetise assets, which means that the creation of new money no longer relies on the creation of new debt to the extent it once did. It is unknown how far the Fed will proceed down this new path.